Why U.S. States Desperately Need an Internet Sales Tax

Because Internet retailers are exempt from collecting sales tax in states where they lack a physical presence, online shopping costs states some $10 billion a year in revenue. Sen. Richard Durbin wants to change that.

The Illinois Democrat is set to introduce a bill, the Main Street Fairness Act, that would empower states to order merchants to collect sales taxes regardless of whether they have any local facilities. Durbin says that would "streamline and harmonize" tax rules and offer states a simple way to boost revenues without raising taxes.

More fundamentally, the change would also level the playing field between brick-and-mortar retailers and their online and catalog counterparts, who can charge lower prices by avoiding sales taxes. The bill would also relieve consumers -- at least law-abiding ones -- from paying the sales tax for online purchases themselves (although that requirement is rarely enforced).

Intense lobbying by Amazon (AMZN), eBay and other online vendors has helped torpedo previous versions of the legislation, which itself is backed by a score of big retailers, including Walmart (WMT). But with states and municipalities across the country facing enormous fiscal challenges, a measure that raises revenue while also leveling the competitive playing field may now find stronger support in Congress.

The status quo with respect to taxation of remote sales is intolerable. State and local governments are losing $10 billion a year that is critically needed to fund education, health care, safety and other public services they're struggling to provide. At the same time, local businesses have always been at a severe and unfair disadvantage in competing with remote sellers.

How e-tailers threaten states
Only five states currently require e-commerce companies to collect sales tax -- Connecticut, Illinois, New York, North Carolina and Rhode Island -- while roughly a dozen more are considering similar proposals. In one notable development, the California State Assembly recently passed a trio of bills that would make out-of-state online retailers pay sales taxes. If passed, the legislation could generate an estimated $1.1 billion for the state and local governments.

Yet such efforts are far from ideal. They result in a patchwork of state tax laws, arguably raising compliance costs. Worse, it allows online retailers to play states off each other by threatening to leave the ones that are weighing such laws.

In South Carolina, for example, state legislators recently reversed themselves and granted Amazon a five-year waiver on collecting sales tax on some purchases that pass through one of the company's distribution centers in the state. The kicker? Amazon offered to hire more employees in the state, in principle boosting revenues. Texas Governor Rick Perry also this month vetoed an Internet sales tax bill after Amazon threatened to close a warehouse in the state and forgo building other facilities.

Tricky politics
For states, however, the risk of losing even a large employer like Amazon must be weighed against the cost of continuing to grant what amounts to a massive tax break. A landmark 2009 study by University of Tennessee researchers projected that over a six-year period through 2012, failing to collect taxes from e-commerce companies would cost state and local governments a total of more than $52 billion.

The obvious solution: federal legislation, which is the only way to ensure a uniform Internet sales tax. There's no reason that online retailers that benefit from soliciting customers in a state shouldn't pay local sales tax. That hurts competition, and it deprives states of essential revenue that they are already legally entitled to collect from traditional merchants.

That said, the politics surrounding Durbin's bills are complex. It pits politically wired online giants against even bigger, more powerful offline retailers. The measure is also likely to face opposition from anti-tax lawmakers who falsely label it as an additional burden on business.

And until the bill is introduced, of course, it's impossible to know exactly what it will say. One thing to watch for -- the minimum level of sales an online retailer must make in a state before it is required to collect taxes. Still, if the legislation resembles similar proposals, it could spur fairer competition among online sellers and local retailers while generating essential revenue for dozens of financially troubled states.